University of Pennsylvania - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: May 18, 2020

Abstract

Central banks offer public liquidity to member (regulated) banks (through lending facilities and promises of bailouts) with the intent to stabilize the financial system. However, nonmember (shadow) banks may receive access to that liquidity through an interbank system. We build a model to understand how public liquidity provision affect interbank linkages and financial fragility. Then, we use unique data on Virginia state banks that contain detailed disaggregated information on interbank deposits and short- term funds and show that the Federal Reserve Act changed the structure and nature of the interbank network in ways that are consistent with the model. We argue that the introduction of the Fed’s liquidity provision may have increased systemic risk through three channels; it reduced aggregate liquidity, created a new vehicle of financial contagion, and crowded out private insurance for smoothing cross-regional liquidity shocks (manifested through the geographic concentration of networks).

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